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The enterprise value – or EV for short – is an indicator of how the market attributes value to a firm as a whole. Enterprise value is a term coined by analysts to discuss the aggregate value of a company as an enterprise rather than just focusing on its current market capitalization. It measures how much you need to fork out to buy an entire public company. When sizing up a company, investors get a clearer picture of real value with EV than with market capitalization.
Why doesn’t market capitalization properly represent a firm’s value? It leaves a lot of important factors out, such as a company’s debt on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company’s valuation.
Simply put, EV is the sum of a company’s market cap and its net debt. To compute the EV, first calculate the company’s market cap, add total debt (including long- and short-term debt reported in the balance sheet) and subtract cash and investments (also reported in the balance sheet).
Market capitalization is the share price multiplied by the number of outstanding shares. So, if a company has 10 shares and each currently sells for $25, the market capitalization is $250. This number tells you what you would have to pay to buy every share of the company. Therefore, rather than telling you the company’s value, market cap simply represents the company’s price tag.
The Role of Debt and Cash
Why are debt and cash considered when valuing a firm? If the firm is sold to a new owner, the buyer has to pay the equity value (in acquisitions, price is typically set higher than the market price) and must also repay the firm’s debts. Of course, the buyer gets to keep the cash available with the firm, which is why cash needs to be deducted from the firm’s price as represented by market cap.
Think of two companies that have equal market caps. One has no debt on its balance sheet while the other one is debt heavy. The debt-laden company will be making interest payments on the debt over the years. (Preferred stock and convertibles that pay interest should also be considered debt for the purposes of calculating value.) So, even though the two companies have equal market caps, the company with debt is worth more.
By the same token, imagine two companies with equal market caps of $250 and no debt. One has negligible cash and cash equivalents on hand, and the other has $250 in cash. If you bought the first company for $250, you will have a company worth, presumably, $250. But if you bought the second company for $500, it would have cost you just $250, since you instantly get $250 in cash.
If a company with a market cap of $250 carries $150 as long-term debt, an acquirer would ultimately pay a lot more than $250 if he or she were to buy the company’s entire stock. The buyer has to assume $150 in debt, which brings the total acquisition price to $400. Long-term debt serves effectively to increase the value of a company, making any assessments that take only the stock into account preliminary at best.
Cash and short-term investments, by contrast, have the opposite effect. They decrease the effective price an acquirer has to pay. Let’s say a company with a market cap of $25 has $5 cash in the bank. Although an acquirer would still need to fork out $25 to get the equity, it would immediately recoup $5 from the cash reserve, making the effective price only $20.
Frankly, knowing a company’s EV alone is not all that useful. You can learn more about a company by comparing EV to a measure of the company’s cash flow or EBIT. Comparative ratios demonstrate nicely how EV works better than market cap for assessing companies with differing debt or cash levels or, in other words, differing capital structures.
It is important to use EBIT – earnings before interest and tax – in the comparative ratio because EV assumes that, upon the acquisition of a company, its acquirer immediately pays debt and consumes cash, not accounting for interest costs or interest income. Even better is free cash flow, which helps avoid other accounting distortions.
The Bottom Line
The value of EV lies in its ability to compare companies with different capital structures. By using enterprise value instead of market capitalization to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued.
Source: New feed
Websol Energy reported the above result for the March Quarter/Year Ended 2017. Even excluding other income ,company performed exceptionally well . More than the result, as per notes, company succeeded in its debt reduction efforts and at the same time doubled its production capacity.
Discl: Personally holding shares of Websol, hence my views may be biased.
Source: New feed
Although value investing properly executed is a low-to-medium-risk strategy, it still comes with the possibility of losing money. This section describes the key risks to be aware of and offers guidance on how to mitigate them.
- Basing Your Calculations on the Wrong Numbers
Since value investing decisions are partly based on an analysis of financial statements, it is imperative that these calculations be performed correctly. Using the wrong numbers, performing the wrong calculation or making a mathematical typo can result in basing an investment decision on faulty information. Such a mistake could mean making a poor investment or missing out on a great one. If you aren’t yet confident in your ability to read and analyze financial statements and reports, keep studying these subjects and don’t place any trades until you’re truly ready.
- Overlooking Extraordinary Gains or Losses
Ignoring the Flaws in Ratio Analysis
Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company’s financial health. The problem with financial ratios is that they can be calculated in different ways. Here are a few factors that can affect the meaning of these ratios:
- They can be calculated with before-tax or after-tax numbers.
- Some ratios provide only rough estimates.
- A company’s reported earnings per share (EPS) can vary significantly depending on how “earnings” is defined.
- Companies differ in their accounting methodologies, making it difficult to accurately compare different companies on the same ratios. (Learn more about when a company recognizes profits in Understanding The Income Statement.)
One of the biggest risks in value investing lies in overpaying for a stock. When you underpay for a stock, you reduce the amount of money you could lose if the stock performs poorly. The closer you pay to the stock’s fair market value – or even worse, if you overpay – the bigger your risk of losing capital. Recall that one of the fundamental principles of value investing is to build a margin of safety into all of your investments. This means purchasing stocks at a price of around two-thirds or less of their inherent value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.
Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent different industries and sectors of the economy. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his “Little Book of Value Investing.” Famous value investor Benjamin Graham suggested 10 to 30 companies is enough to adequately diversify. On the other hand, the authors of “Value Investing for Dummies, 2nd. ed.,” say that the more stocks you own, the greater your chances of achieving average market returns. They recommend investing in only a few companies and watching them closely. Of course, this advice assumes that you are great at choosing winners, which may not be the case, particularly if you are a value-investing novice.
Listening to Your Emotions
It is difficult to ignore your emotions when making investment decisions. Even if you can take a detached, critical standpoint when evaluating numbers, fear and excitement creep in when it comes time to actually use part of your hard-earned savings to purchase a stock. More importantly, once you have purchased the stock, you may be tempted to sell it if the price falls. You must remember that to be a value investor means to avoid the herd-mentality investment behaviors of buying when a stock’s price is rising and selling when it is falling. Such behavior will destroy your returns. (Playing follow-the-leader in investing can quickly become a dangerous game.
After the accounting scandals associated with Enron, WorldCom and other companies, it would be easy to let our fears of false accounting statements prevent us from investing in stocks. Selecting individual stocks requires trusting the numbers that companies report about themselves on their balance sheets and income statements. Sure, regulations have been tightened and statements are audited by independent accounting firms, but regulations have failed in the past and accountants have become their clients’ bedfellows. How do you know if you can trust what you read?
Comparing a company’s stock to that of its competitors is one way value investors analyze their potential investments. However, companies differ in their accounting policies in ways that are perfectly legal. When you’re comparing one company’s P/E ratio to another’s, you have to make sure that EPS has been calculated the same way for both companies. Also you might not be able to compare companies from different industries. If companies use different accounting principles, you will need to adjust the numbers to compare apples to apples; otherwise you can’t accurately compare two companies on this metric
Even if you do everything right in terms of researching and purchasing your stocks, your entire strategy can fall apart if you sell at the wrong time. The wrong time to sell is when the market is suffering and stock prices are falling simply because investors are panicking, not because they are assessing the value of the quality of the underlying companies they have invested in. Another bad time to sell is when a stock’s price falls because its earnings have fallen short of analysts’ predictions.
Source: New feed